Commodities: In terminal decline or recovery ready?

The biggest challenge facing commodities companies next year will be managing oversupply, because it is this and not the slowdown in China's growth rate that is having such an impact on their share prices at the moment.

Supply and demand are surely two sides of the same coin, I hear you say, and so, if the world economy picks up and there is a greater appetite for commodities the balance will be restored.

But even in a world of greater demand, oversupply can exist, and it is this that is acting as a laggard for commodity stocks presently.

And in a worst-case scenario, subdued demand coupled with oversupply could see share prices battered further still.

Supply vs. demand

This made the International Energy Agency's (IEA) prediction for strong growth in the supply of oil next year particularly worrying.

In its monthly report, released on Friday, the IEA upgraded its oil demand growth forecast but also said there was plenty of supply in the pipeline.

It predicted global oil demand would grow by one million barrels per day this year - a rise of 100,000 barrels a day from its previous estimate. Meanwhile, its outlook for oil demand growth for 2014 remained at 1.1 million barrels a day.

On the supply side, the IEA decreased its estimate from the Organisation of the Petroleum Exporting Countries (OPEC) by 645,000 barrels a day last month, but the increase in non-OPEC supply growth is predicted to more than make up for it, up 360,000 to an average of 1.7 million barrels a day.

This would mark the largest annual rise in supply since the 1970s, according to reports.

It is this same oversupply issue Goldman Sachs believes to be afflicting mining stocks.

End of an era

In a recent report on the sector the company described how the decade-long commodity super cycle ended in early 2011.

During the boom the Stoxx 600 Basic Resources Index (SXPP) outperformed the Stoxx Europe 600 Index by 22 times. (From 2001 to 2010 it returned 177% versus 8% from the wider market.)

"It was not hard to make money investing in the miners as China radically increased its demand for commodities such that the miners had no immediate response and prices increased over 500%," Goldman Sachs said.

"This all changed in 2011 as commodity prices reversed their decade-long rise and the miners started to decline," it added.

Since the end of the first quarter of 2011 the SXPP is down 38% compared with an 8% rise from the STOXX Europe 600 Index, even once the recent strong rally is taken into account.

Goldman Sachs predicts iron ore and copper to fall into the oversupply trap next, following aluminium, nickel, zinc and coal. Its timeframe for this is over the next two years.

It also cites another challenge for the companies: "The decline in prices has come at a time of peak capital expenditure, which has led to very low or negative cash flow in some companies. For this reason the relationship between improving macro conditions and the outperformance of the mining sector may no longer hold true, as prices fall first on oversupply and then on cost reduction and productivity drives started by mining firms to minimise the impact on earnings."

Unpopular and unloved

Barclays Wealth & Investment Management's tactical asset allocation committee moved to an underweight position in commodities back in July because it thinks there are better risk-adjusted prospects in other asset classes.

Tanya Joyce, commodities strategist at the firm, identified the wicked combination of slowing Chinese growth and growing supply in key producing regions. "These two factors will likely weaken market balances, which mean the probability of a long-term substantial rally across the commodities complex is quite low, in our view," she explains.

There is variation within the sector, however, with energy Joyce's preferred sub-sector going forward.

"Oil fundamentals remain constructive and we expect prices to remain underpinned by a tight supply-demand balance. Precious metals appear to have the weakest prospects. As monetary policy normalises demand for perceived safe havens, such as gold, will weaken which should cause prices to trend lower. The outlook for the industrial metals sub-sector also looks quite fragile as the slowdown in demand and growth in supply will leave many markets in surplus," she says.

So what about the bullish argument for the asset class?

Robin McDonald, fund manager in the Cazenove Capital Multi-Manager Diversity Range, says: "The sector has gone from being the market darling to being the most shorted by hedge funds and the most under weighted by institutional investors. This was a similar story for Japanese and European equities before they bottomed and I think you've got to get involved in these sorts of unloved areas."

He thinks if investors wait for China and emerging markets to boom again the good news will already be priced into commodity stocks.

Contrarian call

For this reason McDonald and his team have recently invested in the JPMorgan Natural Resources Fund and BlackRock's Gold & General Fund. Five years into a stockmarket bull run they think these mid- to late-cyclical sectors look good value as opposed to "bond proxies" (defensive equities investors are holding for their yield prospects).

Recent data suggests McDonald is not entirely alone in "dipping his toe" into commodities. EPFR Global said industrial sector funds posted their biggest quarterly inflow since it started tracking them in the first quarter of 2003, with the bulk of the fresh money arriving in September.

Commodities sector funds also posted several weeks of inflows as the quarter progressed.

"The shift in commodities sector flows was supported by a reassessment of gold's prospects in light of strong Asian retail demand and the Federal Reserve's decision not to start tapering in October," EPFR Global said.

Gold funds also enjoyed their best month since the previous November when it came to attracting fresh money.

The headwinds for commodities and commodity stocks are well-versed and could easily point to a sector two years into a super-spiral.

As McDonald points out, however, the same arguments were being made towards Japanese equities until the final quarter of last year and investors who took the plunge then have been handsomely rewarded for the risks.

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